Already a member?

Fundamental ETFs - Proprietary Methodologies

Weighting ETF holdings by market capitalization reflects the
market's collective judgment of relative worth of securities.
There is no assurance, however, that this collective judgment is
wise.

Some researchers claim that weighting by market
capitalization/valuation fares poorly in returns compared to
other weighting methods. These include weighting holdings by
fundamental financial measures such as price/earnings, earnings
growth and dividend yield.

Over one hundred fundamental ETFs cover every conceivable
asset class, and most have proprietary weighting formulas based
on multiple financial ratios. These are often referred to as
active, semi-active, or dynamic. (See also our reports on
transparent fundamental ETFs and high dividend yield ETFs.) In
many cases Fundamental ETFs have delivered the goods. Here a
smattering of large-cap fundamental ETF returns are shown against
SPY, an S&P 500 ETF:

The typical fundamental/alternative weighting ETF follows the
following steps:

Identify a list of potential stocks from a cap weighted
benchmark index

Such schemes are based on various mathematical formulas with
an eye to exploiting behavioral psychology. In First Trust's
Alphadex line, for instance, "a value model is applied to exploit
the tendency of investors to extrapolate past results and a
growth model is applied to take advantage of the tendency for
investors to under-react to new information." The Alphadex value
model uses book value-to-price, cash flow-to-price ratios and
return on assets. The growth model uses momentum of price
appreciation over three, six and 12 months, one-year sales growth
rate and sales-to-price ratio. Both models can be used
simultaneously in a single fund.

Fundamental ETFs are fertile ground for theoretical
discussion. At first blush they might seem to imply that there is
a free lunch, something that most economists should not in theory
happen over time. But they may not be a direct broadside against
efficient market theory. Long periods of outperformance does not
ensure perpetual outperformance. Historical stock analysis is
full of examples of successful strategies which bomb the minute
they are declared long-term winners (the supposed value premium
being the most famous example). And clearly the more assets they
attract, the more they will crowd out their own strategies and
help to create an efficient market.

The fees of some fundamental ETFs make their task harder.
Fundamental ETFs must outperform cap-weighted ETFs by 0.5% or so
per year just to recoup their higher fees before they begin to
benefit investors. For instance, First Trust Large Cap Core
AlphaDEX ETF (NYSEArca:FEX), with annual fees of 0.7%,
essentially goes head-to-head with dirt-cheap S&P 500 ETFs at
0.1% in fees.

Co-founder of indexfunds.com, author of two books on
investing, and founder of ETFzone.com, Will has been writing on
indexing issues for 8 years. He holds an MBA from the
University of Texas at Austin.

Co-founder of indexfunds.com, author of two books on
investing, and founder of ETFzone.com, Will has been writing on
indexing issues for 8 years. He holds an MBA from the University
of Texas at Austin.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

Please note that once you make your selection, it will apply to all future visits to NASDAQ.com.
If, at any time, you are interested in reverting to our default settings, please select Default Setting above.

If you have any questions or encounter any issues in changing your default settings, please email isfeedback@nasdaq.com.

Please confirm your selection:

You have selected to change your default setting for the Quote Search. This will now be your default target page;
unless you change your configuration again, or you delete your
cookies. Are you sure you want to change your settings?